Parched

As the summer draws near, we might find ourselves parched for liquidity – not the type that fills a frosty glass with iced tea, but the type that fills a frothy stock market with buy orders.

And when liquidity fails to fill a frothy market, share prices fall…sometimes a lot.

“Liquidity,” simply speaking, is the flow of cash and credit through a financial system. When there is too little liquidity, economic activity tends to slow and/or asset prices tend to fall. When there is “too much,” economies tend to boom – for a while – and asset prices tend to climb…for a while.

But when there is way too much liquidity coursing through a financial system, spectacular dislocations usually occur. We call these events, “bubbles.” One interesting thing about bubbles however, is that they don’t seem so bad while they’re inflating. The resulting damage only becomes obvious after the fact…after the liquidity drains away.

Think of excess liquidity as a 100-year flood. It uproots every structure in its path and lifts it to unnatural heights, while simultaneously destroying the structures’ foundations. And when the flood recedes. Nothing is as it was before. Everything is a mess.

We may be approaching the flood-recession stage. The flood of money that has been elevated asset prices in the U.S. may be on the verge of receding…

For years, the U.S. financial markets have enjoyed an abundance of liquidity. What now concerns us is that we may soon have too little to keep asset prices afloat. In which case, many asset markets would suffer, especially stocks and real estate.

But first, a little history…

In December of 1996, Alan Greenspan uttered his infamous remark, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?”

Greenspan seemed to know at the time, even in 1996, that he was staring a bubble in the face. His monetary response, though, was not to contain it by tightening credit. Instead, he flooded the system with easy money, partly in anticipation of a possible Y2K crisis. But no crisis ever materialized. Y2k came and went. But Greenspan’s additional money in the system stayed, looking for a place to go.

When you have more savings and/or credit in an economy than there are productive places to invest them, you get a bubble: Too much money chasing too few good opportunities. The prudent monetary policy in such situations is to take your medicine and tighten credit. Greenspan, for the most part, has done the opposite.

He has flooded the U.S. financial system with excess liquidity, in the process creating bull markets – or bubbles — in stocks, real estate and bonds, while fostering a related bubble and in consumption (the symptom of which is a huge trade deficit.)

The chart below illustrates the boom and bust of the Nasdaq bubble.

Interestingly, the liquidity that fled the tech sector did not abandon the market entirely. The Russell 2000 Index soared to a new all-time high late last year. The shares of many mortgage lenders and other financial institutions have also soared to new all-time highs during the past two years. At the same time, U.S. bond prices floated to their highest level in more than 40 years – a phenomenon that enabled home prices throughout the country to set new all-time record highs. In other words, the excess liquidity in the U.S. financial system has simply moved from one kind of asset to another.

Alan Greenspan understands that in a liquidity crisis, money stops looking for somewhere else to go. It simply withdraws into the safety of time deposits or the tedious ennui of debt-repayment, neither of which propels share prices higher. So the Fed will be keen to keep the liquidity flowing.

Unfortunately, the Fed does not control every aqueduct into the financial markets. Liquidity black holes often develop spontaneously, without regard for the intentions of the Federal Reserve chairman.

“Liquidity black holes have the feature that they seem to gather momentum from the endogenous responses of the market participants themselves,” write Hyun Song Shin & Stephen Morris in a 2002 research paper on liquidity black holes, “Rather like a tropical storm, they appear to gather more energy as they develop. Part of the explanation for the endogenous feedback mechanism lies in the idea that the incentives facing traders undergo changes when prices change. For instance, market distress can feed on itself. When asset prices fall, some traders may get close to their trading limits and are induced to sell. But this selling pressure sets off further downward pressure on asset prices, which induces a further round of selling, and so on.”

We wonder, therefore, which inflated asset is next in line to suffer the agony of withdrawn liquidity. Will what happened to the Nasdaq eventually happen to the Russell 2000? Or the bond market? Or, heaven forbid, the housing market?

And what, if anything, can investors do to protect themselves? Or to rephrase the question, what will go up when liquidity goes down? The answer: Not stocks. To the extent that all stocks are financial assets, any stock you own—regardless of the quality of the business or the earnings—is at risk of falling during a liquidity crisis.

But there is one thing and one thing only that goes up when liquidity vanishes: volatility.

In a liquidity black hole, therefore, you either want to be a seller of stocks, or a buyer of volatility. For conservative investors (I count myself in that category) a liquidity black hole is to be avoided like a well-done meatloaf. Very few stocks perform well when liquidity recedes. A safety-first approach works best.

But for traders, there may be a profitable solution to the liquidity black hole problem. If you could quickly and easily “buy” volatility in the options market, you could buy the one thing that WILL go up in a liquidity crisis. You’d want to buy the “fear gauge,” better known as the volatility index (VIX).

The Chicago Board Options Exchange (CBOE) was scheduled to begin trading options on two separate VIX-related indexes in late April. But as usual with a new product, the launch date was missed. CBOE hasn’t said when VIX options will start trading.

It has said the root symbol for the optionable VIX will be VXB. There will be another optionable VIX-related index under the symbol VBI. So keep your eyes peeled for these new option products. I suspect a lot of traders, institutions, and hedge funds will like the idea of hedging their stock market exposure with VIX options, which means, ironically, that VIX options should enjoy being a deep and liquid market in a time of market illiquidity.

Since liquidity black holes tend to cause the greatest damage in markets that have been enjoying the greatest price inflations, the prudent investor should try to steer clear of over-hyped and over-priced markets.

Cash is the most liquid financial asset of all. Otherwise, pour yourself a tall frosty glass of VIX options…as soon as they become available.

By Chris Mayer

Wilbur Ross, the billionaire industrialist and savvy investor, seems to have mastered the idea of buying value among the least-favored companies in the market. Ross snapped up bankrupt steel companies three years ago to create International Steel Group, which he recently sold for a cool $260 million profit.

More recently he has been buying up coal companies – snatching up interests in Anker Coal Group and CoalQuest Development. His own International Coal Group out of Ashland, Kentucky, is one of the nation’s top ten producers of coal.

But what will be Ross’ next target? Some say auto part manufacturers. He already owns Japan’s Nikko Electric and Ohizumi Manufacturing, which make alternators and generators. He has been outbid in his attempts to buy a few American auto part makers this year, but the industry is highly fragmented and there are many opportunities.

One auto parts supplier I have been following is Superior Industries (SUP:nyse), which designs and manufacturers cast and aluminum wheels. The stock has been pounded over the last two years:

The company has been aggressively buying back its own shares, with over 200,000 shares purchased in 2004 (obviously, that didn’t work out so well) and the company is still authorized to buy back 3.2 million more shares. Moreover, the company’s president has openly discussed taking the company private (though I note that insiders have not been buying – at least not yet). Still the stock falls…

Granted, auto parts manufacturers are going to struggle, and troubles at General Motors, Delphi and others have dragged down just about anything associated with the automotive business. Competition is fierce.

But at some point a profitable debt-free company with lots of cash becomes an attractive holding. Auto parts companies are obviously on Wilbur Ross’ watch list. Superior is on mine. Maybe they should be on yours, too.